Microsoft Overvalued? Tech Stocks Tumble

Microsoft(Nasdaq: MSFT) President Steve Ballmer caused a row in tech stock-land today after reportedly making some comments that the valuation levels of technology-related companies are overblown. "There's such an overvaluation of tech stocks it's absurd," Ballmer told a gathering of the Society of American Business Editors and Writers, according to Bloomberg News. "And I'd put our company's stock in that category."

That quip may have had something to do with Microsoft's decline today as well as the overall pullback in the Nasdaq composite. The comments are certainly shocking at first blush, and brought out the bold, all-caps headlines that Bloomberg typically saves for multibillion-dollar mergers and the fall of banana republic despots. Ballmer's language is especially eye-catching given that seemingly no business executive outside of Berkshire Hathaway's(NYSE: BRK.A) Warren Buffett ever dares to go on the record and say that his company is anything but undervalued by the market.

But for shaken Microsoft investors fearing that Ballmer is calling the top in the tech stock market, some proper perspective is in order. Seattle's best-known software maker is notorious for managing investors' expectations downward, only to blow those expectations out of the water with its subsequent financial performance. Only earlier this year, the company was guiding analysts to expect fiscal 1999 revenue growth on the order of $2 billion to $3 billion. It ended up reporting $4.5 billion in revenue growth. Whoops!

Since valuation is simply a means of quantifying expectations, calling your company overvalued seems like a good way to ensure that those expectations (in this case, expected earnings growth) never cross the line and become unreachable. Ballmer knows this, and rest assured that he understands better than anyone else on the planet save his boss, Bill Gates, exactly what kind of expectations are built into Microsoft's current share price.

Investors trying to get their arms around Microsoft's "proper" valuation would do well to throw traditional valuation metrics such as price-to-anything ratios out the window and start from scratch by examining the business' value drivers. As CS First Boston analyst Michael Mauboussin and others have pointed out, multiples such as P/E ratios are functions of value, not determinants of value. To determine value, investors must hone in on what makes a company tick -- the cash-in, cash-out dynamics, its ability to generate returns in excess of its cost of capital, the competitive structure of its industry, and the company's own competitive advantage period within the industry.

Slapping a P/E on a massive value creator like Microsoft and saying it is overvalued in comparison to some collection of stocks just ain't gonna cut it. If valuation analysis were really that simplistic, Microsoft would have been "overvalued" virtually from the day it went public 13 years ago. Barring a management coup, a major technological screw-up, or a 180 degree turn in investor sentiment away from the stock market on the whole, Microsoft has a better chance than virtually any other company out there to generate excess returns for decades to come. That's the kind of expectations that are supporting the company's lofty multiples right now.

Ballmer's comments and future conservative statements by the company may succeed in lowering the expectation bar a bit and allow Microsoft to keep surprising to the upside without a hitch, but they will do absolutely zero to alter the underlying value of the business. That value, and how the company goes about creating it, is actually the type of information that deserves to be flashed in bold-face type on financial newswires.